“Covid has brought the future forward by accelerating the digital shift by five years. It is not going to slow down. It will accelerate further,” warned Hironori Kamezawa, president of Mitsubishi UFJ Financial Group, at a Nikkei forum in October.

Some two decades after Japan’s first digital-only banks emerged, the role of digital banking in the economy is no longer in doubt. While they still hold less than 3% of deposits in the country, that is up from 1.6% five years ago. All in the sector accept that competition will only intensify – and are preparing their strategies.

In the last few months alone, two of Japan’s major full-service banks have announced investments in digital banks and services.

Meanwhile the two largest virtual banks – SBI Sumishin Net Bank and Rakuten Bank – are preparing for initial public offerings as early as this year, which could bring them more financial firepower for the next phase of the competition. SBI Sumishin’s IPO involves a share release as well as a capital raising to fund its computer system development.

Analysts put the value of both banks at between ¥300 billion (US$2.1 billion) and ¥400 billion, which would make them the largest IPOs in Japan this year. They would follow the successful IPOs of South Korea’s Kakaobank and Brazil’s Nu Holdings last year, which brought home the message that investors prefer digital banks and are willing to give them much higher multiples. Both SBI Sumishin and Rakuten Bank are valued at more than two times their book value or net worth, while the ratio for most banks is less than one.

Traditionally, Japan’s banking system has been dominated by a handful of major banks, focused on large urban centres, and regional banks, which focus on their home prefectures, each accounting for about a third of systemwide loans and deposits.

But beyond that, virtual banks and retailer-affiliated branchless banks such as Seven Bank are growing rapidly from a small base and are set to outmuscle some of their older peers.

“The whole world is becoming more of an online service type environment. Customer use of bank branches is going down. Virtual interface and security are becoming more important,” added Michael Makdad, senior analyst at Morningstar. “It’s better to be a virtual bank than a small regional bank with a shrinking market.”

Profitability and population trends are in the challengers’ favour.

Both SBI Sumishin and Rakuten Bank had a return on equity of 12% in the year ended March. No other Japanese banks have such levels of profitability. Other strong performers include newer entrants such Orix Bank (8.6%), a virtual lender affiliated with leasing company Orix, and Seven Bank (8.7%), part of the group that operates the 7-Eleven convenience store chain. Japan’s three so-called megabanks have returns on equity in the 6% range, while those of regional lenders range from 3% to 5%.

Virtual banks can keep expenses low because they have no expensive physical footprint, such as branches staffed by clerks, or large on-site computer servers to support their operations, said Hironari Nozaki, professor of finance at Toyo University and a former bank analyst.

The ratio of operating cost to gross profit stood at 48% for Rakuten Bank and 51% at SBI Sumishin as of the end of June. This compares with 60% for Mizuho, 61% for Sumitomo Mitsui and 62% for MUFG. The ratio runs into the 70% to 80% range at Japanese regional banks, Nozaki added.

“Digital banks are clearly more profitable. The difference will become even clearer going forward,” he said. “There will be fewer and fewer people doing financial transactions at bank branches.”

Demographics favour digital banks, according to Nozaki. Young Japanese are more receptive to stock investing than older generations, and tend to gravitate toward online brokers like SBI – the parent of SBI Sumishin –and to opening bank accounts with virtual banks whose services are embedded in online stock trading websites, he said.

Digital-only banks have demonstrated their ability to generate steady profits, even during the pandemic and recent economic upheavals.

“The Ukraine crisis does not really affect their business. And even some negative changes in the Japanese economy, such as inflation, [don’t] hurt their business very much. The pandemic was actually positive in terms of the number of outstanding accounts and deposit growth,” Makdad said.

Still, there are challenges.

“Making money out of banking is difficult in Japan because the yield curve is flat,” said Ryoji Yoshizawa, senior director of financial institutions ratings at S&P Global. The Bank of Japan has had fixed short-term rates at minus 0.1% and long-term rates at zero since 2016, making it hard for banks to profit from the spread – the difference between what they pay to borrow money and what they can charge to lend it. “The key is whether they have an attractive business proposition for customers,” Yoshizawa said.

Virtual banks use scale to make up for low lending margins. Take SBI Sumishin.

A joint venture between Japan’s largest online broker, SBI, and its largest asset manager Sumitomo Mitsui Trust Bank (SMTB), SBI Sumishin has the biggest loan volume among Japanese challenger banks. Using Sumitomo Mitsui Trust’s strength in real estate management, SBI Sumishin became a leading home loan provider in Japan.

SBI Sumishin also provides a platform that allows nonfinancial companies, such as Japan Airlines and department store operator Takashimaya, to offer branded banking services to customers.

The parent company, SBI, also provides a mobile banking platform to seven publicly listed regional banks or banking groups in Japan. “Not every little regional bank is going to do its [own] little app, or be able to,” said Morningstar’s Makdad.

After rapid growth of its business, SBI Sumishin had capital worth 7.6% of its risk-weighted assets, as of the end of June, more than regulators require but less than many Japanese banks tend to maintain.

“SBI Sumishin cannot grow faster without putting more money in,” Makdad said. SBI Sumishin says in its IPO prospectus that it will maintain an appropriate capital buffer for its operations.

Rakuten Bank, which had capital equivalent to 10.5% of risk-weighted assets as of the end of June, has become the leader among digital banks in terms of both deposit volume and the number of accounts, the latter totaling more than 13 million.

To grow it has used its connections with its parent, e-commerce company Rakuten Group, offering embedded financial services for the group’s services such as online shopping, investment and travel booking.

With an IPO on the horizon, the bank is trying to grow beyond the Rakuten ecosystem. In the last couple of years, it has expanded loans for investment property through partnerships with property developers – a business that carries higher credit risks, according to S&P’s Yoshizawa. “Home loans are a relatively easy area to enter, but the interest rates are low. Banks need to examine whether the low rates will make up for the risks they are taking.”

As digital banks push into new areas, traditional banks are not sitting idle.

In June, Sumitomo Mitsui Financial Group (SMFG), the nation’s second-largest bank by assets, announced it was taking a 10% stake in SBI in an effort to strengthen its mobile service offering. SMFG has no capital relationship with Sumitomo Mitsui Trust, the parent of SBI Sumishin Net Bank.

In August, the bank announced plans to establish a virtual bank in the US, which is believed to be an attempt by SMFG to not only enter retail banking in the US but to gain experience in digital banking.

Other megabanks are also shifting resources to digital. Mizuho Financial Group, the third-largest bank by assets, will invest ¥100 billion in its retail banking system between fiscal 2022 and fiscal 2026 to expand online services, including overseas remittances. That is seven times more than it spent in the previous five years. Mizuho declined to elaborate on the timing of an online remittance service offering, saying it will depend on regulatory approval.

MUFG, the nation’s largest bank by assets, will reduce the number of branches it operates in Japan from 425 in March 2021 to about 320 by March 2024. The bank is racing to shift its retail services online as much as possible after seeing the number of customer visits to its retail branches drop by half in the last five years.

Meanwhile, more than 30 regional banks have partnered with Uniqlo Pay, a mobile payment service developed by Fast Retailing and SMFG, to enable customers to make mobile payments at Uniqlo stores. Fukuoka Financial Group’s mobile banking platform iBank has launched AI-powered personalised banking services it developed with Israeli fintech company Personetics.

Have traditional banks gone far enough? Nozaki, the finance professor, does not think so. He believes banks are still just tinkering at the margins. “Banks have yet to embrace more radical shifts for changing their cost structure,” he said.

S&P’s Yoshizawa, meanwhile, wants to see faster change, but expects a more gradual shift.

“When you think about the low profitability of the existing retail banking operations, you’d think that the pace of change would be faster,” he said. But given the difficulty of laying off people in Japan, “The pace of change is understandable.”